“Don’t let anybody tell you that it’s corporations and businesses that create jobs,” Hillary Clinton said last week in Boston. “You know that old theory, trickle-down economics. That has been tried, that has failed. It has failed rather spectacularly. One of the things my husband says when people say, ‘What did you bring to Washington?’ He says, ‘I brought arithmetic.’ ”
The remark, writes my fellow Forbes contributor, Clyde Wayne Crews Jr., Policy director at Competitive Enterprise Institute, “echoes President Obama’s ‘You didn’t build that. Somebody else made that happen.’”
“The main question,” writes Andrew Ross Sorkin from a different perspective in the New York Times, “was whether Mrs. Clinton’s words were more about political maneuvering than reshaping her beliefs.”
Several days later, at a campaign rally in New York, Hillary Clinton said she had misspoken. “I shorthanded this point the other day, so let me be absolutely clear about what I’ve been saying for a couple of decades. Our economy grows when businesses and entrepreneurs create good-paying jobs here in an America where workers and families are empowered to build from the bottom up and the middle out—not when we hand out tax breaks for corporations that outsource jobs or stash their profits overseas.”
Where do new jobs come from?
Amid the political maneuvering, there is, happily, some serious work being done by the Kauffman Foundation and the Institute for Competitiveness & Prosperity to figure out where new jobs actually do come from. The surprising truth is that over the last twenty five years, almost all of the private sector jobs have been created by businesses less than five years old.
“In fact, between 1988 and 2011,” write Jason Wiens and Chris Jackson of the Kauffman Foundation, “companies more than five years old destroyed more jobs than they created in all but eight of those years.”
“Both on average and for all but seven years between 1977 and 2005, existing firms are net job destroyers,” write Wiens and Jackson, “losing 1 million jobs net combined per year. By contrast, in their first year, new firms add an average of 3 million jobs.”
“New businesses account for nearly all net new job creation and almost 20 percent of gross job creation, whereas small businesses do not have a significant impact on job growth when age is accounted for.”
“Policymakers often think of small business as the employment engine of the economy. But when it comes to job-creating power, it is not the size of the business that matters as much as it is the age. New and young companies are the primary source of job creation in the American economy. Not only that, but these firms also contribute to economic dynamism by injecting competition into markets and spurring innovation.”
“Many young firms exhibit an ‘up or out’ dynamic,” write Wiens and Jackson, “in which innovative and successful firms grow rapidly and become a wellspring of job and economic growth, or quickly fail and exit the market, allowing capital to be put to more productive uses.”
“Our public policy emphasis,” writes Roger Martin, Academic Director of the Martin Prosperity Institute at the Rotman School of Management, “should be on enabling entrepreneurial firms to drive innovation and prosperity.”
Why Fed policy isn’t creating net new jobs
This research sheds light on another key economic issue of the day: why doesn’t the Fed’s policies of low interest rates and “quantitative easing”, which shovel hundreds of billions of dollars into the economy, create net new jobs? One part of the answer is clear: the money is only accessible to established firms, which haven’t been creating net new jobs. It’s simply not accessible to the young firms which are the genuine job creators.
What do these established firms use the money for? We know that the big firms don’t use it for investment as much as one might expect. In a Financial Times article entitled “Corporate investment: A mysterious divergence” Robin Harding helped resolve a conundrum that had puzzled the world’s top economists: why is net investment at a measly 4 per cent of output when pre-tax corporate profits are now at record highs – more than 12 per cent of GDP?
In standard economic theory, this makes no sense. When profits go up, companies should be seizing investment opportunities to lay the groundwork for even more profits in future. In turn, that investment should create jobs, generate more capital goods and lead to higher wages. That’s how capitalism is meant to work.
As it happens, we have the kind of thing that you rarely see in economics—a study that enables us to pinpoint the problem by offering “with” and “without” data.
It’s brilliant work by economists from the Stern School of Business and Harvard Business School, Alexander Ljungqvist, Joan Farre-Mensa, and John Asker, in an article entitled “Corporate Investment and Stock Market Listing: A Puzzle?” which compares the investment patterns of public companies and privately held firms. It turns out that the lag in investment is a phenomenon of the public companies more than the privately held firms.
“They find that, keeping company size and industry constant, private US companies invest nearly twice as much as those listed on the stock market: 6.8 per cent of total assets versus just 3.7 per cent.” Large publicly-owned firms are simply not investing enough to grow the economy.
Guess where all that money goes?
So if the Fed’s money doesn’t go into job creation or investment, where does it all go? One part of the answer is that the firms are just sitting on the money, not seeing opportunities for investment. Another part of the answer is given by William Lazonick in HBR and the New York Times: an astonishing amount goes to share buybacks.
“From 2004 to 2013, 454 companies in the S&P 500 Index expended 51 percent of their profits, or $3.4 trillion, on repurchases, on top of 35 percent of profits on dividends… More than three-quarters of compensation for the 500 highest-paid executives came from stock options and stock awards.”
“So who gains from open-market repurchases? Their sole purpose is to give a company’s stock price a manipulative boost, and prime beneficiaries are the corporate executives who decide to do them… For corporate executives, stock-based pay is a ticket to membership in the 0.1 percent top-income club. So why do we let executives manipulate the stock market?”
As The Economist has written, the Blue Chips’ use of share buybacks is the equivalent of becoming addicted to snorting “corporate cocaine.”
“We are reaping the bitter fruits of the ‘shareholder value’ revolution,” as Matthew Yglesias at Slate writes. “Executives at publicly traded companies are paid to generate higher share prices, which is done by hitting quarterly earnings targets. This leads to underinvestment relative to the behavior of managers of privately held firms.”
As Harding concludes, it is “time to stop thinking about corporate governance and executive pay as matters of equity and to regard them instead as a macroeconomic problem of the first rank.”
What to do?
These grim results are not inevitable. Stock price manipulation used to be illegal. That was changed in 1982. We could, as William Lazonick recommends, restore the rule making it illegal once again.
“The S.E.C. needs to rethink the role of the stock market in the economy so that it can distinguish rules that encourage value extraction from those that encourage value creation.”
The leadership of publicly-owned companies also needs to change. The disastrous consequences of systematically pursuing shareholder value as reflected in the current stock are now obvious. It has led to pervasive short-termism which hampered the capacity to compete on a sustained basis in international markets; diverted human and financial resources from needed investments in innovation; dispirited both employees and managers leading to pervasive disengagement; generated “bad profits” that undermined customer loyalty; caused excessive “financialization” of the economy, making it vulnerable to increasingly severe financial crashes; undermined the economic recovery from the Global Financial Crisis; drastically reduced rates of return on assets and on invested capital; appropriated gains that flowed from workers’ improvements in productivity; and led to secular economic stagnation and increasingly unsustainable economic inequality.
A fundamental shift in the way these are firms are run is needed so that they give primary attention to deliver value to customers, through investment, innovation and treating their employees and partners right. The stakes are high.
Will politicians from either party be able to articulate the issues in ways that go beyond party labels? “We have arrived at a turning point,” as the agenda for the Global Peter Drucker Forum 2014 taking place in Vienna Austria next month points out. “Either the world will embark on a route towards long-term growth and prosperity, or we will manage our way to economic decline.”